A Minor Tweak to a Momentum Investing Model Could Have Changed Returns Dramatically

Do-it-yourself investors are getting frustrated with playing “model may I,” sparking a debate among quants about how best to beat the market. Importantly, over which time horizon should they measure momentum? Momentum models, whether they assess prices on an absolute or relative basis, have led to some losses, particularly late last year and early this year.

One popular tactical approach, known as the Dual Momentum strategy, has taken a lot of blame. When applied to global equities, it tracks momentum in world stock markets to identify areas of strength, while providing the flexibility to shift into safer short-term Treasuries in times of stress. It kept some investors aggressively positioned in stocks in the last quarter of 2018 when the S&P 500 index tumbled 14%. It then signaled a more defensive posture in January just as stocks were beginning to rebound.

To make matters worse, investors using the Dual Momentum model were so frustrated by its recommendations that they ignored or delayed following them when it suggested changing course, according to a recent Newfound Research study. That violated a basic principle of systematic investing: follow the rules.

The missed cues reflected “the gap of risk” between what academic literature claims—that trend following can garner market-beating long-term returns—and its implementation, the study says. In other words, it’s hard to stick to one strategy when many similar-sounding strategies produce very different results. There are 62 exchange-traded funds that capture momentum in some way, according to Bloomberg. Their variations help explain why one ETF posted a 16% trailing 12-month return into mid-January while another recorded a loss of 26%.

One of the variables in Dual Momentum models is their time frame, or a look-back period. If U.S. stocks outperform Treasuries over 12 months, they tell investors to sit in stocks. If U.S. stocks in that time also outperformed foreign stocks, the model would point to S&P 500 stocks. If not, it would signal buying foreign stocks. If all else fails, the model would point you to short-term Treasuries. It’s simple to use and execute by rotating in and out of three inexpensive ETFs. Not counting costs, this model last year lost 8%.

A minor tweak would have changed returns substantially. Using a 10-month time frame to assess momentum last year would have turned the loss into a gain of 0.7%. If the model was based on nine months, it would’ve posted a decline worse than the 12-month model. “Same thesis. Same strategy. Slightly different specification. Dramatically different outcomes,” wrote Justin Sibears, a co-author of the study. “That single year is probably the difference between hired and fired for most advisors and asset managers.”

Sibears isn’t suggesting that investors dump the so-called 12-month look-back for 10 months because of last year’s returns. But he tells Barron’s that investors could cut their risk by having money in several different time-horizon strategies. Diversifying in this way and rebalancing annually puts returns closer to the median result of the portfolios, says Sibears.

But at what opportunity cost, asks the inventor of the Dual Momentum model for global equities, Gary Antonacci, who wrote a retort to the study. He compares Sibear’s suggestion to betting red and black at roulette: Will it smooth out volatility—sure, but “it is not a smart bet.” Longstanding evidence shows that 12-month look-backs work best for tactically investing in stocks, he adds. To Wes Gray, Alpha Architect’s founder, “The question isn’t about time horizon; it’s about what you are trying to achieve—do you want crisis alpha or tail-risk hedging?”

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